Franchise Disclosure Documents – Understanding Item 19
Franchise Disclosure Documents are an important part of the due diligence that would-be franchisees should follow before they take on a franchise. Investors want to make sure that the support they receive from the parent company will be enough to keep the franchise going. The franchise itself needs to know that it can rely on franchisees to uphold the standards of the brand they are working with. The Franchise Disclosure Document helps with this.
How to read and understand a Franchise Disclosure Document (FDD)
The franchise disclosure document is a document that contains 23 key points that cover everything that a would-be investor needs to know. These documents were created because there was once a time when salespeople would try to get investors to buy into a franchise by being liberal with the truth. Since there was not a lot of information out there for investors to go on, franchisees would often find that they were forced to take information on faith. The FDD was introduced as a way to force full disclosure, and give investors a clearer understanding of what they were putting their money into.
It is important that would-be franchisees read the FDD fully, and understand it, before agreeing to anything. It is a good idea to take it away and read it at your leisure and seek advice if there is something that you do not understand.
If you want a full breakdown of all items on the FDD, you can refer to our detailed post titled “How to Read a Franchise Disclosure Document” at the link here.
It is also a good idea for a potential franchisee to speak to current franchise holders before they invest. The FDD includes a list of all franchisees, and this is a valuable resource. Franchisees will usually be happy to discuss their experiences, and to explain whether the start-up costs they experienced were as expected, and how the business went during the first few months or years. Ask how long it took to break even and to turn a profit, and whether there were any unexpected expenses.
Franchise documents can be lengthy and complex, and it is easy for people who are not well-versed in finance or business to feel overwhelmed by their contents. Even someone who is an experienced business person may find that they struggle to understand a document that is centered on a business other than their usual niche. Take your time and be sure to query anything that you are not sure about. If you are planning on hiring a manager to take care of the franchise for you, then make sure that the franchisor allows you to be ‘hands-off’ in that way, and that any limitations to how the business is run are clearly understood.
If you have plans for concessions within a store, or diversifying or putting a ‘twist’ on the business, confirm that those are allowed too. Some franchises require their franchisees to follow the business template to the letter so customers have a uniform experience everywhere.
So why is item 19 on a Franchise Disclosure Document so important?
Item 19 on the Franchise Disclosure Document is the part that relates to earnings claims, and it is now known as the Financial Performance Representations section. The FPR should give a franchisee a clear idea of what the path to profitability for a franchise will look like. It is an estimate, or a guideline, based on past performance, and is not guaranteed to work out for any given company but it is something that is useful as a guide.
Item 19 financial disclosures are optional. Franchisors are not required to provide them. Until recently, many franchises would not disclose earnings, in part because they were trying to reduce the risk of legal liability if a franchisee failed to make money and believed that the disclosures were not accurate.
In recent years, however, attitudes towards disclosures have started to change. Now, around two-thirds of franchises do choose to report their financial performance – up from 52% in 2014. Earnings claims are an opportunity for a company to showcase their potential, and they can help to make a franchise look more credible to a potential investor.
Exactly what is disclosed in an FPR will vary depending on the company, but there are some figures that are frequently listed, including:
– Average gross sales for a combined number of units
– Adjusted gross sales for an individual unit
– Store sales, listed by square foot
– Costs (including leases, labor, stock)
Exactly what is disclosed will depend on the type of business. A hotel might list occupancy rates and room rates. A coffee shop might list footfall and daily takings. Most FPRs focus on the most recent year, but in some businesses, the disclosure might cover multiple years.
FPRs are usually focused on past performance. While a franchise is allowed to do projections, past performance tends to be safer in terms of liability. A franchisor might opt to disclose results from just a subset of outlets in a particular geographic area, and this is something that a would-be investor needs to be aware of. If the franchises that are in the FPR are in an area similar to where you are planning to open your franchise, then the data may be useful. If the area where you are thinking of opening your franchise is very different, then you might find the data next-to useless.
The Northern American Securities Administrators Association has published new guidelines that streamline who FPRs should be published, and that are stricter about what can and cannot be included. This makes it easier for a franchisee to read an FPR, and also to compare information from one franchisor’s FR to another.
What is the FTC Franchise Rule (and the 23 items it must include)?
Franchising is not a new idea, and over the years this valuable business practice has had some rocky moments. The Federal Trade Commission started to focus on franchising practices in 1970, and started the process of legislating franchising in 1971. The FTC Franchise Rule was not fully formalized until 1979. The act, once put in place, prohibited unfair and deceptive acts and methods of competition.
The FTC Act empowers the commission to lay out other rules, such as the Commission’s Franchise Rule. The Commission has put a lot of time and effort into publishing consumer education resources, and into fighting against business opportunity fraud. Businesses are required to make disclosures covering several key categories, to help would-be investors make clear decisions.
The Franchise Disclosure Document covers a lot of key points, including:
– The franchisor, and a list of any parents predecessors, and affiliates
– The names and relevant business backgrounds of key people involved in the business
– Any current or past litigation
– Whether anyone involved in the business has ever declared bankruptcy
– Initial franchise fees
– Other fees
– An estimate of the initial required investment costs
– Any restrictions on the suppliers/sources of products and services
– Whether or not there is an exclusive or protected territory for the franchisee
– A list of trademarks associated with the business
– A list of patents, copyrights or proprietary information that is owned by the company
– Whether or not franchisees are required to oversee the day to day running of the business
– Any restrictions on the goods or services that the franchisee can offer under the brand
– Rules for renewal, transfer or termination of the franchise, and dispute resolution
– Information about public figures associated with the brand
– Financial performance representations (if the franchisor wishes to provide these)
– If financial information is provided, there should be a material basis to back up any representations made
– A list of existing outlets and current franchisees
– Financial statements
– A copy of any contracts that the franchisee would be required to sign
– A note of receipt to indicate that the prospect has been given a copy of the document
Note that the FTC Franchise Rule does not require that a business disclose the unit performance statistics of the system to a new buyer of a franchise in the way that would be necessary under the Securities and Exchange Law.
Investing in a franchise can be high-risk, but with due diligence it is possible to make positive returns. There are many rip-off franchise opportunities that are a rip-off, promising that franchisees will get access to equipment to sell a product or service – for example vending machines, medical billing software or t-shirt printing tools. The franchisor may even promise to help the buyer find a market for whatever it is they are being given the equipment to produce. The support that the scammers offer is limited, if not non-existent, and the buyer is left with expensive equipment, no way to keep it running, and no buyers to sell to.
For this reason, it is vital that would-be investors read the full FDD before they invest. Many “business opportunity” providers do not comply with the franchise rule at all and do not provide an FDD. This simple layer of due diligence can go a long way towards helping buyers find a reputable company to work with.
There is a civil penalty for companies that fail to comply with the Franchise Law. The penalty can be up to $11,000 for each compliance violation.